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This article first appeared in EQDerivatives' subscription Commentary & News service.
While uncertainty surrounding populist parties across Europe is creeping into equity markets, the Euro Stoxx 50 Volatility Index is only clearly reacting to French election risk, opening an opportunity for investors to extract risk premia around the event.
Barclay strategists said in a recent client note that investors should look at puts on the VSTOXX, buying an April 2017 22 option on the index for EUR1.70. Other potential trades include best of puts on a range of euro-denominated broad-based indices, or a put spread collar on the Euro Stoxx 50.
Christian Kober, European equity derivatives strategist at Barclays in London, said a risk premium is priced in for the French elections, while nothing is priced for the Dutch in mid-March. “With the February VSTOXX future falling, the V2X term structure is upward sloping again but still presents a distinct kink in the April maturity,” he said. As a result, the VSTOXX April roll costs are the highest ever seen over the past five years, Kober added.The trade will pay off if the polls change and the election risk does not materialize, which is where the risk is already pricing, said Kober.
Europe’s far-right political parties have been making gains in the polls prior to the German, French and Dutch elections this year. All three countries have seen increased support for far-right, Eurosceptic political parties, however, the latest polls suggest a majority success of any far-right party is unlikely.
In the variance market, the SX5E and the DAX are pricing in German election risk differently according to Kober. “While the [September/December 2017] risk premium has collapsed in the SX5E, it is still visible in the DAX term structure and the implied excess move is about 3.3%,” Kober said. “And in the vanilla markets, the CAC 40, DAX, SX5E and [Euro Stoxx Banks] are all pricing a French excess jump [1.4%], while the German election risk is only priced in the DAX and the CAC with a modest excess volatility of about 1.5% and 1.2%, respectively.”
The VSTOXX term structure shows very clearly that there is a risk expectation for the French election, whilst the German election risk premium has fallen [from 3.6% to 2.6%] in the SX5E term structure Kober told EQDerivatives. “The DAX [is showing] three similar kinks of 4% excess volatility in average, while the SX5E shows a major kink of 5.3% excess volatility in the March/June 2017 maturity and smaller bump for the June/September 2017,” he said.
Historically, the March/June 2017, June/September 2017, and the September/December 2017 forward variance levels are low to mid-range but have come down recently, according to Kober. “While this might seem attractive for some investors, we would note that the quarterly roll down is high, which makes an outright long forward variance trade unattractive and expensive to carry.”
 | Georgia Reynolds is a reporter at EMEA at EQDerivatives, based in London. A recent graduate from City University London, Georgia has been studying and producing print and multimedia journalism for five years. |
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